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Why Tullow Oil Plc Is Surging Today

Shareholders in Tullow Oil (LSE: TLW) received a considerable boost today as A.P. Moeller-Maersk A/S ventured into the world of East African oil through a partial acquisition of drilling licenses in the region.

This follows a brutal nine-month period that has seen share prices across much of the oil sector drowning in double-digit losses, with the only exceptions being Petrofac and those few companies who have been subject to takeover offers or interest.

Tullow shares rose by almost 17% this morning, although until today investors had been staring down the barrel of losses amounting to nearly 50% of their holdings.

The details

A.P. Moeller-Maersk A/S has announced an agreement to purchase half of Africa Oil Corp’s shares in drilling licences that it holds for five different sites in Kenya and Ethiopia.

The group will make an upfront payment of $365 million and could make another payment of up to $480 million further down the line, with the latter being dependent upon the outcome of further asset appraisals.

The news has been seen as a considerable endorsement in the quality of the assets in question and, to a lesser extent, the region in general, while also reducing concerns over Tullow’s ability to fund the capital expenditure necessary for it to progress with its projects.

Further implications of this are that Tullow could now benefit over the longer term from having close connections to Moeller-Maersk, a financial behemoth in its own right, as this could help it to attract further investment into its other projects over in West Africa.

Projects such as the TEN oil fields in Ghana have already been hailed as Tullow’s main growth platform for future years.

Any investment that it can attract into these areas will help it to bring forward the day when it hits its longer-term production targets, which could see total group production eventually rising from 70,000 barrels per day to as many as 200,000.

Gearing is high & most valuation methodologies irrelevant

Tullow’s 2014 loss and low projections for earnings in 2015 render the more simple valuation metrics, such as price-to-earnings ratios, almost redundant at present.

This is while other traditional methodologies such as the discounted cash flow approach are also unhelpful given their reliance upon cash flow predictions and therefore, oil price predictions. We all know how reliable those have proven.

Just about the only thing that can be said with any certainty is that Tullow Oil’s balance sheet is beginning to look a bit stretched.

After taking into account the effects of last year’s impairments,  this year’s borrowing and nine months of share price weakness, debt/equity at Tullow Oil is now just over 1x, while gearing has recently exceeded the 50% milestone.

These balance sheet metrics highlight the importance of Tullow’s targets for increased production and the timeliness of Moeller-Maersk’s investment into East African oil.  

Verdict

Tullow Oil clearly has a quality asset base, with great potential on the African continent. One that, if financed and developed correctly, should lead to increased shareholder returns and an improved valuation for the group in future periods.

Nevertheless, in today’s environment all oil companies are a risky prospect for investors, but particularly those with smaller businesses that are still heavily reliant upon speculative success in exploration.  

Tullow is one of these more risky companies and, as such, a relatively risk averse investor like myself would probably prefer to view today’s rally as providing an ideal opportunity to exit, rather than any kind of incentive to consider new or continued investment.

However, having said this, today’s news could mean that those who have a greater appetite for risk or speculation than myself may just find themselves rewarded in future years for having got involved or stayed the course.

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James Skinner 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.