A robust trading statement from Tullow Oil (LSE: TLW) may have helped the energy explorer canter to fresh multi-month peaks last week (it is now dealing at levels not seen since last April). But I am afraid this fresh release is still not enough to make me revise my cautious take on the firm.
Tullow, which has slung out a stream of positive updates over the past few months, declared on Wednesday that it had “delivered strong operational and financial performance in 2017 against the backdrop of continued industry volatility,” the company beating both cash flow and production estimates.
The FTSE 250 explorer managed to chuck out free cash flow of £500m last year, it said, while forecast-beating production of 89,100 barrels of oil per day (BOPD) from its West African assets resulted in group production of 89,600 bopd.
Chief executive Paul McDade struck a bullish tone looking ahead,too, commenting: “With our diverse low-cost assets and high-graded exploration portfolio, enhanced by recent licence additions in Côte d’Ivoire and Peru, we have a strong foundation to grow the business and further reduce our debt.” Net debt is anticipated to have plummeted by $1.3bn in 2017 to $3.5bn.
It’s not all rosy!
Many investors are considering Tullow’s rapidly-improved balance sheet and booming production levels, allied with the improved outlook for oil prices in recent months, as reasons to plough into the business today. But the likelihood of prolonged oversupply still makes it a risk too far in my opinion. The Energy Information Administration said last week that US production would hit 11m barrels per day by the end of 2019.
City brokers are expecting earnings at Tullow to leap 338% during 2018. This still leaves it changing hands on an expensive forward P/E ratio of 20.9 times however, providing plenty of scope for a heavy share price reversal should non-OPEC supply continue to crank ever higher.
Tullow Oil isn’t the sole commodities share I would shift out of today as I reckon Rio Tinto (LSE: RIO) could be hit by prolonged supply overhangs in the near term and beyond as well.
In the case of the mining giant I am fearful more specifically that the scale of iron ore gains over the past year could come back to haunt it, as it’s a segment from which it sources 60% of group earnings.
Indeed, rampant price gains for the steelmaking ingredient drove the FTSE 100 firm’s share value 25% higher in 2017. And this leaves Rio Tinto dealing on a forward P/E ratio of 13.5 times, a reading that is far too high in my opinion given that a possible iron ore correction remains a very real scenario. Indeed, I would consider a multiple below 10 times to be a fairer reflection of the firm’s high-risk profile.
Just last week Australia’s Office of the Chief Economist warned in its latest quarterly report than prices of the commodity could tank in 2018 to average $53 per tonne before falling further to $49 next year. The body said that these declines will be “due to growing low-cost supply from Australia and Brazil and moderating demand from China.”
Reflecting expectations of falling metal values, City analysts are predicting a 14% earnings drop in 2018. And with buckets of new material from across the globe set to keep flooding the market, investors should be braced for a period of extended bottom-line weakness.
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