Why I Would — And Wouldn’t — Buy Afren Plc

Today I am looking at the benefits and pitfalls of stashing your cash in troubled oil explorer Afren (LSE: AFR).

Balance sheet on the brink

Following what has been a prolonged period of share price turbulence — shares in Afren have conceded 95% since the beginning of August in oft-rocky trading — a strange calm has enveloped the stock in recent days as investors eagerly await the next chapter in the company’s troubled history.

But there is a huge possibility that the current hiatus represents the calm before the storm. Investors have adopted a ‘wait and see’ attitude as industry rival Seplat (LSE: SEPL) mulls over launching a formal takeover attempt. The company first made overtures towards Afren in December and is still to make an official bid despite numerous deadline extensions, the latest of which expires this coming Friday.

In the meantime Afren remains in severe financial peril, with a deferred $50m amortisation payment and $15m interest payment for a 2016 bond due towards the end of the month. And news this week that Taipan Resources is seeking $10m in damages from Afren, related to alleged breaches of a joint venture agreement in Kenya, has thrown yet more mud into the water.

With cash seeping out of the business at a rate of knots, and the explorer being hampered by stratospheric debt levels, the amount of time Afren can continue treading water for is quickly running out.

Pretty value on paper

It could, however, be argued that the risks of investing in the oil explorer is already baked into the share price at current levels.

Undoubtedly Afren faces a gigantic effort in getting the bottom line moving in the right direction, and City analysts expect the business to follow a 61% decline in 2014 with an additional 77% slide this year.

Despite these forecasts of further heavy profits pressure, Afren still changes hands on a P/E multiple of 6.8 times forward earnings, comfortably below the value yardstick of 10 times or below. And for 2016 this gets even better, with an expected 128% earnings bounce on the back of production rap-ups driving the readout to a meagre 2.3 times.

Oil prices to keep on collapsing?

But rather than reflecting a bargain, I believe that these numbers merely reflect the upheaval facing Afren as well as the wider oil sector, and reckon that the very real prospect of further earnings downgrades leaves these figures on shaky ground.

Black gold prices have staged a mild rally since mid-January’s multi-year troughs and the Brent benchmark was recently trading around $58 per barrel, leading many to believe that prices may have already struck their bottom.

However, supply levels are expected to remain abundant for some time to come. Indeed, the International Energy Agency (IEA) warned today that stocks amongst OECD countries is likely to creep towards the record high of 2.83 billion barrels seen during the 1990s, advising that “it will take time for investment cuts to make more than a relatively small dent on production.”

Combined with signs of stalling economic activity from China to the eurozone, oil prices could resume their sharp downturn sooner rather than later, casting doubt on the financial viability of Afren’s asset base.

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Royston Wild has no position in any shares mentioned. The Motley Fool UK has recommended Afren. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.