Why I’d Buy Tullow Oil plc, But Would Avoid Gulf Keystone Petroleum Limited

While the past is not necessarily an accurate guide to a company’s future performance, it does provide an indication of its future potential. And, although a company can move from multiple years of losses and into profit, a company that is already highly profitable and has a track record of delivering bottom line growth could have a better chance of delivering impressive financial figures moving forward.

Take, for example, Tullow Oil (LSE: TLW). It has been profitable in four of the last five years, with last year being an understandably atypical year as a result of the sudden and violent fall in the price of oil. However, prior to this fall, Tullow was performing relatively well and had been able to deliver over $1bn of pretax profit in two of those profitable years.

And, looking ahead, Tullow is expected to quickly return to profitability after last year’s disappointing performance, with the company’ switch away from being an explorer and towards a producer set to help it to generate over $600m of pretax profit over the next two years. While this is short of Tullow’s $1bn+ figure from a few years ago, it would still represent a relatively strong performance when you consider that the oil price is almost half of its level from one year ago.

Of course, Tullow’s track record also tells us that its earnings are likely to be volatile in future. However, since it will be focusing more on production, its financial numbers should be more consistent than it the past, although it remains a stock for less risk averse investors. Still, its price to earnings growth (PEG) ratio of 0.4 indicates that it has a sufficient margin of safety to take into account a relatively unstable earnings profile.

While Tullow has an impressive track record when it comes to profitability, the same cannot be said of Gulf Keystone Petroleum (LSE: GKP) (NASDAQOTH: GFKSY.US). It has been loss-making throughout the last five years and, looking ahead, is forecast to remain so in each of the next two years. Clearly, that is disappointing for its investors and it is, therefore, difficult to see a clear catalyst that could push its share price higher.

That’s even more the case because Gulf Keystone is a fully fledged oil producer and, as such, investors will inevitably demand a black bottom line. If it were an explorer, then losses would be understandable during the exploration phase and the company’s share price would be highly dependent upon news flow, but as a producer (and even in a lower oil price environment), there is an expectancy to turn a profit, which Gulf Keystone is not yet achieving and is not expected to realise over the next two years.

Furthermore, Gulf Keystone continues to trade on a generous valuation even though its share price has fallen by 56% in the last year. For example, while it has a high quality asset base, it trades on a price to book (P/B) ratio of 1.54 which, when you consider that Tullow is larger, more diversified, profitable and yet has a P/B ratio of 1.3, seems rather high.

As such, Gulf Keystone does not appear to be attractive at the present time, while Tullow offers growth potential, a low valuation and the scope for investor sentiment to improve significantly over the medium to long term.

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Peter Stephens 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.