Will Gulf Keystone Petroleum Limited Follow Afren Plc Into Administration?

In what has been akin to an emotional rollercoaster for investors in Afren (LSE: AFR), the oil exploration company was finally put into administration last week. While it had been coming for a long, long time, there is still a degree of surprise that Afren was unable to continue as a going concern.

After all, and despite having huge debts that it simply could not service, in recent weeks there had been some hope among investors that under the terms of a new financial restructuring package, the company could continue and begin to mount a comeback. However, with production levels falling dramatically and the company being unable to reach a new agreement with its creditors, Afren’s time was up and, as a result, its investors walk away with a 100% loss.

Clearly, this is hugely disappointing for investors in Afren. Certainly, companies going bust is nothing new and, as investors, we accept this risk in order to gain access to the considerable rewards that shares can also offer. And, in Afren’s case, the main cause of its woes was an external factor (the collapse in the price of oil) which prompted the risks it had taken with regard to large levels of debt to come home to roost. In other words, it took a risk in leveraging its balance sheet and, with revenue having fallen, became unviable as a business.

Therefore, the question must be asked: if it can happen to Afren, could it happen to other oil explorers and producers?

Without doubt, the answer to that question is ‘yes’. And, on the face of it, the outlook for Iraq/Kurdistan-focused oil producer Gulf Keystone Petroleum (LSE: GKP) is not good. That’s because, like Afren, it has a considerable amount of debt on its balance sheet and, more importantly, it is still not receiving the monies owed to it for oil sales from the Kurdistan Regional Government (KRG). Certainly, the KRG has stated that it intends to commence a regular payment cycle from next month, but details on exactly how much cash this will mean for Gulf Keystone Petroleum remains unclear.

With the KRG expecting an increase in production in 2016, it has stated that it intends to increase payments moving forward. While this is encouraging news for Gulf Keystone Petroleum, hopes for cash inflows have been built up before and, as yet, the company is still waiting for a backlog of payments. In fact, to such an extent that it is now selling oil domestically at a cut price.

Undoubtedly, Gulf Keystone Petroleum has a hugely appealing asset base that, in the long run, has the potential to deliver vast levels of profit. The problems it faces, however, are also considerable. As well as a lack of cash receipts for oil that has already been produced, it faces the prospect of a continued low oil price as well as the potential for increased political instability in a region that remains a conflict zone.

As such, and while Gulf Keystone Petroleum may not follow Afren into administration, its risk/reward ratio appears to be unfavourable, thereby making it a stock to avoid at the present time.

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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.