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Why I Think It’s Time To Sell Small-Cap Oilies Like Afren plc

During the early 2000s the global economy was growing as fast as it’s ever grown, as both the West and emerging markets pushed ahead. The rise of China meant that commodity prices went through the roof. The oil price reached levels that were previously unheard of.

This was the time when the oil industry was the place to be. Just as people invested in tech start-ups at the time of the tech bull market of the 1990s, people were investing in small-cap oil stocks during the Noughties, because this was where the money was being made.

This was an incredible investment. Wasn’t it?

One of the companies created during this era of fevered commodities speculation was Afren (LSE: AFR). From the IPO launch price of 54p in 2005, the shares rose to 171p. Clearly this was an incredible investment. Wasn’t it?

The share price fell precipitously when the financial crisis hit, but that was the case with most small-cap companies. The stock price recovered quickly, and by the early 2010s Afren was even starting to turn a slim profit. Even in late 2013, the share price was as high as 169p.

The business was confidently investing in more exploration and production facilities across the world. This was an ambitious firm, aiming to grow oil reserves and oil production. After all, with commodities so expensive, the more you could produce, the more profits you would make.

But what happens as you try harder to increase production, is that you take more and more risks. Conducting seismic surveys, building rigs and drilling wells all cost money – a lot of money. And if you are not currently turning much of profit, then all this investment means only one thing: more debt.

This is like the tech bubble of the 1990s

Now most companies have a certain amount of net debt… but too much is dangerous. As of the end of 2013, Afren had $739 million of net debt.

Then, in the middle of 2014, something else happened: the oil price started falling. This meant that a business that was gradually beginning to make profits was suddenly loss-making. So then you know what will happen to the share price.

At the time I am writing this article, Afren’s stock is now priced at 5.95p a share. That makes the total market capitalisation of this firm £65 million. So how can it pay its debt? It’s quite simple – it can’t.

Just as most of the internet start-ups that grew out of the 1990s tech bubble made very little (if any) money and eventually went to the wall, I’m afraid many small-cap oil shares are likely to suffer a similar fate. The Afren story is a casebook example of why knowing which shares to avoid is as crucial as knowing which shares to buy.

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Prabhat Sakya 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.