As a value investor, I am always on the look-out for cheap stocks to add to my portfolio. On the face of it, Tullow Oil (LSE: TLW) looks like a good candidate. Its share price is down 75% over the past five years. However, the primary commodity it produces, oil, has been soaring during the past year. So, has the market completely under-valued the company’s potential? Let’s delve a little deeper.
A heavily-indebted business
Tullow Oil is a company that has been in trouble long before the pandemic struck. In 2019, the Africa-focused business reduced its production guidance due to drilling problems. When the pandemic struck, it was forced to take significant impairments and exploration write-offs totalling $1.2bn. At that time, its net debt stood at $3bn, resulting in a gearing ratio of three times.
This matters hugely, as in order to secure a debt refinancing package with its creditors, in May 2021 it was required to hedge the price of oil in order to stabilise income. In 2022 and 2023, 75% of its sales volumes have a ceiling price of $78 and a floor price of $51. In 2024, this will be reduced to 50% of sales.
This turned out to be terrible timing for the business, as oil prices have surged over the past six months and are now well in excess of $100 a barrel. Given the hugely cyclical nature of the oil industry, there is no guarantee that prices will remain elevated beyond 2024.
When a share price falls 95% over an extended 10-year period, that raises alarm bells for me. It could be because the wider industry is in decline (a factor clearly not present here). It could be attributed to the fact that the company possesses a dwindling asset base. Or it could simply be a poorly run business. However, the company was able to survive the worst crisis to hit the industry in 30 years.
Tullow’s key assets in Ghana, the Jubilee and TEN oil fields, have significant oil reserves. The Jubilee field in particular saw production rise 29% throughout 2021 as new wells were bought onstream. To date, only about half of its expected reserves have been produced. There is also significant development work just outside Jubilee. There, the company’s estimated ultimate recovery is 170m barrels of oil, of which only 10% has been produced to date.
With the successful refinancing of its debt complete, the company’s immediate cash flow problems look behind it. It intends to use the raised cash for working capital purposes. This includes a capital expenditure allowance of $350m to maximise the value from the Group’s producing assets, as well as exploration activities.
Is Tullow Oil a buy?
Although it has a number of high-growth, short payback projects in the pipeline, it is very difficult for me to look beyond the immediate headlines. Revenue, total production, and realised oil prices were all down on 2020. And this is all set against a wider commodities industry that is enjoying something of a renaissance.
Net debt only fell by 12.5% and stands at $2.1bn. That is two times the market cap of the firm. With the oil price hedge in place for another two years, I just can’t see revenues moving upward significantly from here. Therefore, I won’t be buying.