Will Staggering Debt Hold Back Premier Oil Plc & Tullow Oil Plc Despite Rising Oil Prices?

Since trading at a nadir of $27.88/bbl in late January, Brent crude prices have rallied a full 33% to sell for $37.20/bbl today. Shareholders of beaten-down oil-producers will surely cheer this news and hope the rally holds. However, even if it does, billions of dollars of debt at Premier Oil (LSE: PMO) and Tullow Oil (LSE: TLW) could keep share prices trading at current levels for some time.

North Sea producer Premier Oil’s net debt as of the end of 2015 stood at $2.2bn, representing a staggering gearing ratio (total debt/total capital) of 78%. The good news from the balance sheet is that $400m of cash, access to $850m of credit, and current cash flow levels mean it will be able to ride out low crude prices for several years with no issue.

Like all oil companies, one of Premier’s first reactions to cratering oil prices was to slash exploration-related capex. The company drilled no exploratory wells in 2015 and only has two planned for this year. Despite this, large projects set to come online and smart acquisitions will see the company ramp up production greatly in the coming years. The $135m acquisition of E.ON’s North Sea assets will add roughly 15k barrels of oil equivalent per day (boepd), while the Solan field coming online will add a further 12k. Altogether, daily production for 2016 will increase roughly 17% year-on-year to 65-70k boepd.

Cost-cutting has brought the company’s operating costs per barrel down to $16, with further cuts in the 5% to 10% range expected for 2016. These lower costs combined with large increases in production leave Premier in decent shape as oil prices rise. However, having $2.2bn of debt on the books will mean that for the medium term free cash flow will be directed towards paying loans, rather than ramping up exploration or returns to shareholders through dividends and share buybacks.

Production increases

West Africa-focused Tullow Oil still has a mountain of debt, but is in a better position than Premier. Year-end gearing was 58% due to net debt rising to $4.2bn. Like Premier, Tullow’s $1.9bn in cash and undrawn credit lines are sufficient to see the company through several years of cheap crude.

The similarities don’t end there as Tullow has its own large project coming online midway through 2016, the TEN field in Ghana. Production from TEN will increase Tullow’s total daily production by some 13% in 2016 and a further 33% in 2017. The company is targeting opex costs of a mere $8/bbl for TEN and its other major asset in Ghana, the Jubilee field. With 73-80k boepd expected to come from these two fields in 2016, Tullow’s cash flow position will improve significantly in the coming year.

For long-term investors, I believe Tullow’s stronger balance sheet and lower-cost assets make it a better option than Premier. A less leveraged balance sheet and greater production volume at lower costs will allow for shareholder returns much more quickly at Tullow than Premier.

Both of these options remain highly risky though, as they lack the diversified revenue streams of larger oil majors. Investors who are more risk-averse will likely find them less appealing options than the Motley Fool’s Five Shares To Retire On.

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Ian Pierce 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.