The Premier Oil share price just fell another 20%. Here’s what I’d do

Is the Premier Oil share price now too cheap to ignore? Roland Head reckons big gains are possible, but the risks are significant.

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The Premier Oil (LSE: PMO) share price has fallen by another 20% over the last month. Although the stock has tripled from the horrifying 10p low seen in March, many shareholders will still be facing painful losses on this stock.

Are the shares now too cheap to ignore? I’ve been digging into the latest investor updates from the firm to find out. My conclusion is that big gains are possible, but the risks are significant.

The only thing that matters

I think there’s a lot to like about Premier. It has some decent oil and gas production assets, with relatively low costs. The firm’s operational management always seems strong to me and production is usually on target.

Production should rise soon too. Premier recently agreed to buy BP‘s share of the Andrew Area and Shearwater fields in the North Sea. They’re expected to deliver a significant increase in production and some new oil and gas reserves.

There’s only one problem — debt. Premier’s net debt is just short of $2bn. That’s more than four times its market-cap of $430m. In practice, this means Premier’s lenders have almost total control over the business.

In my view, this is why Premier Oil’s share price has fallen since the BP deal was confirmed. The deal may only benefit Premier’s lenders.

Shareholders will pay

After months of negotiations, its lenders agreed to let the company buy the BP assets. It makes sense, because the extra cash flow should speed up debt repayments. However, the deal will only go ahead if shareholders provide the cash needed for the initial payment of $210m. Essentially, shareholders will be funding Premier’s debt repayments.

As I write, Premier Oil’s share price is 35p. At this level, I estimate the company would have to sell around 485m new shares to raise that $210m. This would increase its total share count by around 50%, from 922m to around 1,400m shares.

The exact numbers will be slightly different, depending on how the new shares are priced. But the principle’s the same. Shareholders who don’t buy new shares will face significant dilution. In other words, their share of Premier’s future earnings will fall.

I think Premier Oil’s share price could go either way

The BP acquisition should mean future profits will be higher. Hopefully, this will offset the dilution from the new shares. The problem is that the BP fields are already fairly mature. Premier Oil has only provided production and cash flow guidance for the next four years. I’m pretty sure all of this cash will be used to repay the firm’s debts.

What happens after this? We can’t be sure. But I suspect we’ll start to see production fall unless the fields get new investment. We also need to remember decommissioning costs — Premier will take on $240m of future abandonment obligations as part of this deal.

If the oil price surges higher over the next couple of years, Premier Oil’s share price could perform well. But the combination of too much debt and high levels of dilution is a potent cocktail.

Shareholders could face a nasty hangover, so I’m staying away.

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 of the 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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