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Should Circle Oil Plc Replace Soco International Plc & Gulf Keystone Petroleum Limited In Your Portfolio?

Circle Oil (LSE: COP) has risen almost 40% since early April, and it will publish its 2014 results on 1 June: you may do well to buy its shares before results are out, perhaps in place of SOCO (LSE: SIA) and Gulf Keystone Petroleum (LSE: GKP) in your portfolio… here’s why:

Circle Oil

First off, I would never invest a penny in these kind of shares unless my portfolio was properly diversified. Also worth bearing in mind is that I rarely argue in favour of smaller oil companies these days, as most of them are not suitable for value investors, given that their risk profiles are hard to model.

Circle Oil bears the hallmarks of a value proposition, however. 

To start with, it boasts a strong track record with regard to revenues and earnings generation, while its cash flow from operation is one element I like. The shares have halved in value since September, when they traded around 27p, and you’d have recorded a 60% loss on your invested capital if you had invested in it five years ago. 

However, recent news from Morocco — where well flows were 140,000 cubic metres per day, and production is expected to start at the end of next month — combine with trading multiples that point to a hard bargain: forward multiples for net earnings and adjusted operating cash flow stand at 7x and 3x, respectively. 

This is also a bet on political stability in Egypt and Morocco — did you notice the “Emaar Misr IPO seen as sign of Egyptian resurgence” headline in The Financial Times last week? 

GKP & SOCO

Soco is not an oil company that strikes me as being at the forefront of competition. Time and again over the last decade, SOCO management has often bragged its potential, talking of terrific upside for shareholders based on its net asset value… but its shares still trade in line with its level they recorded in September 2005. The dividend doesn’t look safe, and SOCO has fallen out of favour with a few brokers this month, too (Goldman Sachs price target 151p; JP Morgan price target 168p).

The problem is that SOCO has been a promising investment for a long time, but in recent months it has proved to be more cyclical than many pundits and analysts had expected. With forward trading multiples for net earnings and adjusted operating cash flow at 22x and 7x, respectively, SOCO remains a strong sell in my view. I don’t know if this is the bottom for its earnings cycle, but if you are invested, you’d do well to close the trade right now at 188p a share, I’d argue. 

That said, I prefer SOCO to GKP. Dilution risk points to plenty of downside for GKP shareholders, and it could be argued that GKP may need to raise about $50m of new equity by the end of the third quarter, based on its cash flow statement, working capital management and heavy investment requirements.

Its relative valuation, at 12x its forward adjusted operating cash flow, signals risk. At 35p a share, GKP has lost almost 50% of value this year, and is down 76% over the last two years. If you wonder whether you should bet on it, consider that there’s better value elsewhere…

That said, if you truly believe that the risk of investing in Circle Oil is acceptable, and you are also tempted to snap up GKP and SOCO right now, then you must include these three high-risk stocks in a properly diversified portfolio, comprising the shares of more solid, less cyclical and cash-rich businesses that are set to deliver rising dividends and 20%+ all-in returns annually for many years to come. Want to know more about our top picks? 

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