Will BP plc & Tullow Oil plc Drown In A Sea Of Cheap Oil?

I would have expected the oil price slump to have squeezed supply significantly by now, but it hasn’t happened yet. Or if it has, any drop-off has been matched by falling demand.

Eight consecutive weekly increases have lifted US inventories to 487m barrels, up from 385m at the turn of the year and at levels not seen at this time of year for over 80 years, according to research from AJ Bell. The news helped push WTI crude to  around $40 a barrel. The world is awash in a sea of cheap oil, the question now is which oil stocks will swim and which will sink.

Major Concern

FTSE 100 oil giant BP (LSE: BP) has sunk another 17% over the past six months but its recent third-quarter results have given it some buoyancy. Its vigorous campaign of cost-cutting and divestments helped offset the damage wreaked by falling oil, allowing BP to post a profit of $1.23bn, way lower than the $2.38bn it posted one year earlier but far better than the market expected.

BP can’t survive by cutting costs forever without damaging the underlying business, and the lower oil falls and the longer it stays there, the greater the threat to its dividend. Chief executive Bob Dudley has reassured investors that the dividend is a “strong priority” but he can’t buck the oil market forever, and it could fall victim to a far stronger priority unless the price rebounds. Dudley has even talked about raising the dividend, but I would rule that out until the price recovers. On a current yield of 6.8% investors are already amply rewarded. Don’t assume that will be sustained.

With oil stocks such as BP and Royal Dutch Shell paying 13% of the £73.7bn in FTSE 100 shareholder distributions forecast for 2016, investors will be clinging onto any optimistic number they can find. Well, here’s one: the International Energy Agency predicts that demand will reach 95.5m barrels a day in the fourth quarter of 2015, up 1.6% year-on-year. The world still needs its oil.

Empty Basin

But does it need Tullow Oil (LSE: TLW)? Its share price is down 52% in the past six months. It hasn’t been helped by this week’s news that its Emesek-1 exploration well in Northern Kenya will be plugged and abandoned after its failure to find commercial hydrocarbons.

At some point the cheap oil cycle will bottom out, and when it does then Tullow should enjoy a relief rally, the only question is when? Investment bank UBS reckons we are pretty much there. It just upgraded Tullow to buy, hailing it a “well-financed company with quality assets and a proven development track-record, offering long-term oil price exposure at the bottom of the cycle”.

Tullow has taken swift action to steady itself, cutting costs by $500m and suspending the dividend, and has cleverly hedged half of next year’s production at $75 a barrel. BP and Tullow still need more expensive oil and can probably cling on well into year before drastic measures are required. Will the tide of cheap oil have ebbed by then?

Both these stocks could sink further if the oil price stays at $50 a barrel or less. If you think this makes them a risky gamble then don't worry, there are some really exciting opportunities on the FTSE 100 today.

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Harvey Jones 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.