Is Afren Plc Plus Nostrum Oil & Gas PLC A Sound Resources Combination?

Just when you think things can’t get any worse for investors in Afren (LSE: AFR), they do. In fact, shares in the beleaguered oil producer have fallen by a whopping 23% in the last week alone and this brings their total decline to 95% during the course of 2015.

Of course, the falling oil price has a lot to do with it and, looking ahead, things could be set to worsen on that front. That’s because there remains a major supply/demand imbalance across the globe, with oil producers seemingly unwilling to cut production to try and restore the oil price to a more ‘normal’ level. As such, further pressure on the oil price in the short run seems relatively likely.

Financial Problems

The main problem for Afren, though, is its debt pile. It currently stands at around $1.3bn which, for a company the size of Afren, is very high. In fact, to provide an idea of just how large Afren’s debts are compared to its income statement, Afren recently reported revenue of $130m for the first quarter of 2015. That’s around 10% of the company’s debt and shows that it would take 2.5 years for Afren to repay its debt even if all of its revenue was profit which, of course, it is not. As such, Afren looks set to continue to find it very difficult to make its interest payments, as well as repay the amounts borrowed, and this could act as a major brake on its future share price performance.

Unusual Performance

Of course, not all oil stocks have fallen thus far in 2015. One company that has bucked the trend is Nostrum (LSE: NOG). Its shares have risen by 28% since the turn of the year, with investors becoming increasingly positive about the company’s medium term prospects even if the gains made by the oil price in recent months may be coming to an end.

In fact, Nostrum’s growth prospects for the next couple of years are surprisingly positive. For example, it is expected to grow pretax profit from £10m in the current year to around £172m next year. That’s a superb rate of growth and puts Nostrum on a forward price to earnings (P/E) ratio of just 11.9, which indicates that its shares have a sufficiently wide margin of safety to as to offer generous rewards and limited risks moving forward.

In addition, Nostrum also has relatively sound finances. For example, it has a debt to equity ratio of 103% which, while relatively high, appears to be manageable. Evidence of this can be seen in the fact that Nostrum has had positive net operating cash flow in each of the last two years, with interest charges being covered six times by operating profit in 2014, and ten times by operating profit in 2013. As such, and unlike Afren, Nostrum appears unlikely to suffer from declining investor sentiment as a result of concerns surrounding its sustainability as a business.

Looking Ahead

Clearly, a falling oil price will hurt the bottom lines of oil sector operators and, looking ahead, there is a decent chance that black gold will remain very volatile. However, with a relatively wide margin of safety, upbeat growth forecasts and sound finances, Nostrum appears to offer an appealing risk/reward ratio, while Afren’s share price is likely to come under further pressure as a result of its vast debt pile. As such, a sound way forward seems to be to buy the former and avoid the latter.

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Peter Stephens 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.