Shares in FTSE 250 member Tullow Oil (LSE: TLW) fell by more than 20% this morning. The drop came after the company cut production guidance for this year and warned a recent discovery might be less valuable than expected.
Here, I’ll explain what this news might mean for shareholders and give my view on the Tullow share price.
Heavy, heavy oil
Tullow shares rose in August and September when the firm reported two oil discoveries, Jethro-1 and Joe-1. These were the first two wells drilled in TLW’s Orinduik licence, off the coast of Guyana.
The discoveries appeared to support the company’s resource estimates for the acreage and investors were hoping for news the wells produced good quality light oil. This kind of oil is favoured by refineries and attracts the highest prices — the Brent Crude benchmark is a light crude.
However, Tullow says the oils recovered from Jethro-1 and Joe-1 were heavy crudes with a high sulphur content. Oil like this often sells at a big discount to benchmarks such as Brent. As a result, Tullow and its partners are now reviewing whether these discoveries are still commercially viable. They may not be worth developing.
The company has plans to drill other wells elsewhere in this area and remains hopeful better quality oil will be found. But today’s news is certainly a big disappointment.
Exploration disappointments are unavoidable, but production shortfalls are more of a concern, in my view. Tullow said today full-year production from its West African portfolio is now expected to average about 87,000 barrels of oil per day (bopd).
This is a the second time in six months the firm has cut its production guidance — in June, Tullow said its full-year forecast was for 90,000-98,000 bopd. In July, this was cut to 89,000-93,000 bopd. Now it’s been cut again.
The problem lies with the firm’s TEN project in Ghana. This has suffered a number of technical problems that have limited production this year. Performance is expected to improve from the end of November into 2020, but this is yet more disappointing news from the firm’s flagship project.
Cash flow weakness?
Lower oil production means cash flow will also be affected. The company said today free cash flow guidance for 2019 is now $350m, significantly lower than the forecast of $450m provided in June.
I don’t expect this to cause any significant problems for the company, but it does seem likely to slow the pace at which Tullow can repay debt.
That’s a concern to me, because the firm’s half-year accounts showed net debt of nearly $3bn. That’s more than 10 times this year’s forecast after-tax profit of $265m. As a general rule, I prefer to see net debt of less than four times net profit. For Tullow, that would be about $1bn.
I’ve been cautious about Tullow for some time. I’ve felt debt remained too high and the shares weren’t particularly cheap. The firm has also suffered a number of setbacks over the last 18 months.
After today’s fresh round of disappointments, I will be continuing to avoid this stock. I think there are better opportunities elsewhere in the oil sector.
Roland Head has no position in any of the shares mentioned. 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.