The Tullow Oil (LSE: TLW) share price has jumped 550% over the past 12 months. At first, this performance looks incredible, but it’s a bit misleading.
This time last year, the initial pandemic shockwaves were reverberating around the world. Asset values were plunging, and investors were dumping stocks, bonds and commodities.
Shares in Tullow didn’t escape the sell-off. At one point, the stock was changing hands at just 9p.
Since then, as the outlook for the global economy has improved, the Tullow Oil share price has recovered. But even after this performance, it’s still trading nearly 80% below its five-year high of 278p.
As such, I think the stock could have further to run. Today, I’m going to explain why.
The outlook for the Tullow Oil share price
As an oil producer, Tullow’s long-term outlook is linked to the price of its product. One of the most common ways of valuing any business is to look at its potential to generate cash over the long term.
By estimating how much cash the company can generate over the next five-10 years, analysts can determine how much the stock’s worth today. This method is called a discount cash flow analysis.
Since the end of April last year, the price of Brent crude oil has increased from just under $10 a barrel to nearly $70. Therefore, a simple back-of-the-envelope calculation suggests Tullow is far more profitable today than it was at the beginning of last year.
This therefore implies a discounted cash flow analysis will tell us the company is worth significantly more today than at the beginning of 2020.
Of course, this method isn’t perfect. There are a multiple of other factors to consider. For example, Tullow hedges its oil production. This provides some insulation against oil price volatility, although it does come at a cost. Other factors to consider include the company’s cost of production, capital spending outlay and debt costs.
Debt reduction
Despite these challenges and risks, the overriding conclusion from higher oil prices is that the Tullow Oil share price is also worth more today than it was this time last year.
What’s more, if oil prices stay where they are, the company’s valuation could increase future as Tullow would be able to use its excess profits to reduce debt.
Companies with high levels of debt tend to have lower valuations because they’re riskier investments. If Tullow can reduce its borrowings meaningfully, investor sentiment towards the business could improve dramatically.
That’s assuming creditors don’t lose patience with the business. If they do, they may pull the rug out from under the enterprise. That would leave Tullow gasping for air and could result in its collapse.
If this trend of a rising share price linked to a surging price of oil continues, I think the company’s outlook will only improve. So, despite the speculative risks facing the business, I’d buy the stock for my portfolio today.
