The Motley Fool

Why Tullow Oil plc is on my radar

Africa-focused explorer Tullow Oil (LSE: TLW) surprised investors last week by unveiling plans to raise approximately £607m through a rights issue. Because of this, its shares have been heavily punished by the market — they’re down 34% since the start of the year.

Having failed to anticipate the fall in the oil price, Tullow is now in a difficult spot. Following a series of major oil discoveries, the company took on huge debts to develop the new fields. With net debt of $4.8bn and an uncomfortably high net gearing ratio of 5.1 times, these debts no longer look sustainable in today’s price environment, and Tullow is under huge pressure to shore up its balance sheet.

However, Tullow’s rights issue would reduce its net debt by less than a fifth, despite increasing its share count by more than half. This means the company’s ongoing deleveraging efforts will still be dependent on the company making further asset sales. And as the Brent oil price falls to its lowest level since November, Tullow faces major execution risks with its asset disposal programme.

But despite this, there are also a number of bullish catalysts on the horizon. The company has maintained its outstanding exploration track record, as it recently made an exciting discovery in Northern Kenya. It has found evidence of recoverable oil in the northern limit of the South Lokichar basin, and other discoveries in the area may be yet to come.

Moreover, Tullow’s capital expenditure budget is falling as the company nears completion of the initial phase of its TEN oil project off the coast of Ghana. Capital expenditure after its Uganda farm-down deal is expected to fall to around $350m this year, down from $0.9bn in 2016. And as production is expected to ramp up this year, the company is expected to generate growing free cash flows, which will no doubt help the company to pay down its debts.

Less risky

If you’re instead looking for a less risky investment in the sector, then Cairn Energy (LSE: CNE) could be a better pick. Cairn has undergone a major transformation in recent years as the company exited from India and repositioned itself as a full-cycle E&P company.

Unlike many in the sector, Cairn has net cash of $335m on its balance sheet and is fully funded for 2017. The company’s prospects are centred on developing oil fields in the North Sea and Senegal, where it has combined 2C reserves of more than 2.7bn barrels. Exploration around the Atlantic Margin are ongoing, and Cairn estimates further block wide exploration potential of around 500m barrels of gross mean risked resource.

Cairn is also on track to return to production this year, meaning it will soon be in a position to fund much of its ongoing exploration and development costs from organic cash flows.

Valuations may be a tad expensive though. It seems that Cairn’s share price implies oil will head towards $70 a barrel in the long run, which is significantly ahead of the Brent forward curve.

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Jack Tang 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.