The Motley Fool

3 Reasons To Sell Tullow Oil plc And Buy Royal Dutch Shell Plc

It’s been a grim 12 months for shareholders in oil explorer Tullow Oil (LSE: TLW). The firm’s share price has fallen by almost 60%, and there seems little hope of any respite in the near future.

At least that’s my reading of this morning’s first-half trading update. Although Tullow has increased its full-year production guidance to 66,000-70,000 bopd from 63,000-68,000 bopd, the financial outlook remains poor, in my view.

Claim your FREE copy of The Motley Fool’s Bear Market Survival Guide.

Global stock markets may be reeling from the coronavirus, but you don’t have to face this down market alone. Help yourself to a FREE copy of The Motley Fool’s Bear Market Survival Guide and discover the five steps you can take right now to try and bolster your portfolio… including how you can aim to turn today’s market uncertainty to your advantage. Click here to claim your FREE copy now!

Tullow expects to report gross profit of just $300m for the first half of 2015, a 57% fall on the same period last year.

Lower oil prices mean that despite higher production, pre-tax operating cash flow is expected to have fallen 44% to just $500m during the first half of the year.

Assuming a similar performance during the second half, Tullow could be nearly $1bn short of the cash needed to fund this year’s planned $1.9bn investment programme. The result is that Tullow’s net debt will continue to rise. It’s already $3.6bn, 16% higher than at the end of last year. I expect a further rise during the second half of 2015.

Tullow’s supporters will probably say that this doesn’t matter, as when the TEN project in West Africa starts producing oil next year, production and thus cash flow will rise rapidly.

My question is whether this new production will be profitable enough to repay debt and fund shareholder returns if oil prices stay at current levels.

I’m not convinced and would sell Tullow and buy Royal Dutch Shell (LSE: RDSB) in today’s market.

1. Integrated advantage

Like BP, Shell has a bid advantage over Tullow Oil. Since the price of oil fell, its downstream (refinery) division has been making bumper profits.

This offsets falling profits from oil and gas production (upstream) and is a key advantage of investing in integrated oil companies like Shell, rather than exploration and production companies, like Tullow and BG Group.

Of course, Shell recently bought BG Group, providing a happy ending for long-suffering BG shareholders.

I don’t expect a similar outcome for Tullow, though.

2. Asset value

The reason for this is simply that Tullow still looks expensive. The valuation measure usually used by professional investors in oil and gas is the enterprise value to reserves ratio.

I recently calculated this to be $16.20 per barrel of oil equivalent (boe), for Shell. For Tullow, the current figure is $23/boe. That’s not especially attractive. Even after the bid premium, Shell only paid $19/boe for BG Group.

Unless Tullow’s reserves rise, I believe its share price needs to fall.

3. Income

Tullow’s days as a lucky oil and gas explorer with a premium P/E rating are over, in my view. The firm has not made a big discovery for some time and is struggling with a potentially toxic combination of low oil prices and rising debt. The dividend has been cancelled and seems unlikely to return anytime soon.

In contrast, Shell’s gearing will remain relatively low even after the BG acquisition. Chief executive Ben van Beurden has promised to maintain the dividend this year, giving a prospective yield of 6.5%.

Even if this payout is cut slightly in future years, it will still be a lot higher than anything Tullow is likely to provide.

5G is here – and shares of this ‘sleeping giant’ could be a great way for you to potentially profit!

According to one leading industry firm, the 5G boom could create a global industry worth US $12.3 TRILLION out of thin air…

And if you click here, we’ll show you something that could be key to unlocking 5G’s full potential...

It’s just ONE innovation from a little-known US company that has quietly spent years preparing for this exact moment…

But you need to get in before the crowd catches onto this ‘sleeping giant’.

Click here to learn more.

Roland Head owns shares in Royal Dutch Shell. 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.