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Why I Would Sell Tullow Oil plc And Buy easyJet plc

As my experience as an investor has grown, I have come to realise that sometimes it pays to listen to macro themes as they play out. Whilst I wouldn’t bet the farm on my macro view (I wonder how many investors have lost money shorting the FTSE 100 over the last week or so?), there is plenty to be said for including a trend — either emerging or long-standing — as part of your thesis to buy, sell or hold your shares.

With this in mind, I’ve been taking a look at the current activity in the oil sector to see if the current weakness is throwing up any opportunities.

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According to a report from the International Energy Agency on 10 July, they see more downward price pressure on the black stuff for the rest of this year and into 2016. This is based on:

  • Global oil demand growth forecast to slow to 1.2 mb/d in 2016;
  • Global oil supply surging by 550 kb/d in June;
  • OECD industry inventories hitting a record 2 876 mb in May.

Whilst other factors persist, I think we can nicely sum it up as a supply and demand issue – there is too much oil being produced for the demand. This isn’t being helped by oil-producing nations, who currently refuse to cut production, not to mention Iran now being allowed to sell more oil into the market.

What did my research throw up?

Sometimes it can pay to listen to the market, sometimes not. This brought me to Tullow Oil (LSE: TLW). Three years ago to the day, this company’s shares traded at 1414 pence; today, they change hands for just 285 pence each. Surely, though, this makes them a bargain – right? Well, I’m not so sure – here’s why:

  • The company has little to no pricing power – it sells a commodity into a market, the price of which is determined by that market – whilst it can hedge the price in order to give it some visibility, that price is likely to fall going forward;
  • Even at these low levels, the shares are still priced at over 20 times forward earnings – that doesn’t strike me as particularly cheap;
  • The company has net debt – as regular readers will note, I wrote at length about Afren and how that company was being suffocated by its debt. Whilst I’m sure Tullow isn’t in the same situation, it is something I consider;
  • Finally, I feel that the company is overvalued compared to its sector. Indeed, the tool on Stockopedia has it overvalued by 42%! However, it is true that it will have been compared with some junk, I feel that it is important to note.

Sliding oil prices aren’t bad for all shares– some stocks will see their price rise as oil prices fall. One such company is easyJet (LSE: EZJ).

The chart below illustrates the point rather well – see how easyJet has started to creep up while Tullow has fallen, despite increasing its production guidance at the start of the month.

Of course, should the price of oil rise substantially then we would see the opposite, or at least that is what we should see.

But the fact of the matter is that easyJet prospered, even with oil trading at over $100 per barrel. To me, it is simply a better share, made more attractive by the lower price of oil. Just looking as some basic metrics:

  • The forward PE is around 12 times earnings – that’s cheaper than the market average;
  • Return on capital employed is: 24.9% — second in its sector and in the top 10% of the market;
  • Return on equity is: 29.2% — fourth in its sector and in the top ten percent of the market;
  • The forward yield of 3.6% is greater than the market median of 2.95%.

Final Thought…

As I have written before, it can be foolish to trade simply based on just one piece of news or metric. However, with a little bit of research, investors can unearth some real gems whilst avoiding areas that could well lose them money.

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Dave Sullivan 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.