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Is it game over for the Premier Oil share price?

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It’s been a painful few weeks for Premier Oil (LSE: PMO) shareholders. The oil and gas producer’s share price has fallen by more than 50% since the start of October, when it hit a 52-week high of 146p.

As a shareholder, I have a keen interest in this situation. So today I’m going to take a fresh look at Premier. I’ll explain why the share price fall has been so brutal, and ask whether the shares are still worth buying.

What’s really happened

You probably already know that the price of Brent Crude oil has fallen by around 30% since the start of October, from a high of $86.70 to about $60.

It’s no surprise that oil stocks have suffered. But you may wonder why Premier’s share price has fallen by over 50% when the price of oil has only dropped about 30%.

There’s a good reason for this. The cost of producing a barrel of oil is relatively constant over short periods. For our purposes, we can consider it to be a fixed cost. This means that if the price of oil rises, the extra sales revenue is almost all profit.

In a rising market, the firm’s profits from selling oil will rise more quickly than the price of oil. On the other hand, when the price of oil falls, Premier’s profits will fall more quickly than the oil price. This is an effect known as operating leverage.

Although I’ve simplified it considerably, I estimate that a 10% increase in the price of oil could increase Premier’s profits by as much as 14%. I hope this makes it easy to understand why oil shares can move so sharply when the price of oil changes.

Still making good progress

A recent trading update made it clear that Premier is still making good progress. Production is up, spending is down, and operating expenses are under control, at $17-$18 per barrel.

The firm has also put in place new hedging contracts for 2019, covering over 30% of planned production. They guarantee a minimum oil price of $69 per barrel during the first half of the year, and of $72 per barrel during the second half.

Chief executive Tony Durrant expects net debt to fall by $320m to $2.4bn this year, which he says will reduce the group’s net debt-to-EBITDA ratio to 3x. Although this is still high, Mr Durrant expects this ratio to fall further in 2019. I believe this could open the door to a more normal valuation for the firm.

Too cheap to ignore?

Broker forecasts for 2018 and 2019 have actually risen over the last three months, despite October’s oil price slump. Analysts appear to remain confident that the company can return to profit and continue repaying its debts.

If that view is correct, the stock’s 2018 forecast price/earnings ratio of 4.6 may be too cheap. A forecast P/E of 2.7 for 2019 also seems to be pricing in a lot of bad news. I continue to rate the shares as a buy.

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Roland Head owns shares of Premier Oil. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.