3 Oil Stocks Set For Strong Recovery: Tullow Oil plc, Premier Oil PLC And Ithaca Energy Inc.

Brent crude was comfortably above $100 a barrel a year ago, but collapsed to below $50 by January this year. However, there’s been a bit of a recovery since, and we haven’t seen below $60 for a couple of weeks.

The shares of mid-cap companies Tullow Oil (LSE: TLW) and Premier Oil (LSE: PMO), and smaller firm Ithaca Energy (LSE: IAE) have also bounced of late — but remain well below their 52-week highs. Tullow is down 54%, Premier 51% and Ithaca 65%.

There’s far greater bounce-back potential in these stocks than in the oil supermajors: for example, the shares of Shell are currently 19% below their 52-week high, while those of BP are off just 10%.

Of course, the sheer size of mega-caps — such as Shell and BP — makes them less risky, which is why they didn’t fall as heavily as the likes of Tullow, Premier and Ithaca in the first place. But, if you’re looking for big returns when the oil price cycles to higher levels — which sooner or later it will — you need to embrace some risk.

Tullow, Premier and Ithaca have abundant potential, but also appear to be well positioned should an oil price recovery take some time.

In times of tough trading, cash is king. Strong relationships with lenders and the ability to keep generating cash from the business are crucial to weathering the storm.

Tullow, Premier and Ithaca all have decent immediate cash flow protection with 50%+ of near-term production forward hedged at higher prices per barrel than the current price: Tullow at $86 for 2015, Premier at $98 for 2015, Ithaca at $91 through to June 2016.

It helps to be a low-cost producer, too. Tullow and Premier both have operating costs of less than $20 per barrel of oil equivalent (boe). Ithaca, which is smaller and also operates exclusively offshore in the North Sea, has higher operating costs. These are currently running at $40/boe, but are set to fall to $30/boe (more in line with the North Sea average) with the start-up of production from its Stella field in 2016.

The flexibility to meaningfully reduce or re-phase capex in parts of the business is also useful for conserving cash, and Tullow, Premier and Ithaca are all demonstrating this. Previously dividend-paying Tullow and Premier are additionally conserving cash by suspending payouts. Non-core asset sales are another means of boosting the coffers, and Premier and Ithaca have been able to do this in recent months.

The backing of banks and other lenders is crucial, and the three companies have all delivered positive news on this score. Ithaca this week announced funding that will cover forecast peak debt prior to the 2016 Stella start-up. Initial annualised production from Stella to Ithaca is expected to add a transformative 16,000 boepd to the company’s current 12,000 boepd. Tullow, too, has announced a new financing package to help bring a substantial production-boosting project through to first oil next year, while Premier has increased its main bank facility on improved terms and says the company has “significant liquidity if the weak macro environment offers new opportunities, as it has done in the past”.

Not all oil companies have the strong qualities of Tullow, Premier and Ithaca that I’ve been talking about — just look at Afren. Sure, my three picks are not without risk, but I think the risk-reward balance looks reasonable. All three companies trade on a 2016 price to earnings growth ratio of below 0.4, suggesting a wide margin of safety is built into their current valuations. In addition, the attractions of these companies means there’s also the possibility of a share-price boosting takeover approach.

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