North Yorkshire potash miner Sirius Minerals has been a crushing disappointment for its shareholders. Many small investors have been left nursing painful losses.
Today, I want to look at another popular FTSE 250 resource group, Tullow Oil (LSE: TLW). A chain of operational and financial problems have caused the Tullow share price to fall by 85% over the last year. At a last-seen price of about 34p, TLW stock is now trading close to its all-time lows. Are the shares a bargain, or could this company be the next Sirius Minerals?
One big difference
There’s one big difference between Sirius and Tullow. Sirius has no revenue and needs about $3bn to start production. By contrast, Tullow Oil is expected to generate revenue of about $1.6bn in 2020, netting a profit of $132m, according to City forecasts. Based on this figure, Tullow shares trade on just five times forecast earnings.
That certainly looks cheap. My only concern is that it might be too cheap. Is the market telling us something?
Debt problems
Unlike Sirius, Tullow was able to borrow money to develop its big assets, the Jubilee and TEN oil fields. The only problem is that now these fields are in production, they aren’t producing as much oil (or cash) as expected.
The group’s free cash flow fell from $390m to $350m in 2019. This gives us a rough measure of how much debt Tullow can repay each year. The only problem is that in 2020, free cash flow is expected to fall to just $150m.
Tullow’s net debt was $2.8bn at the end of 2019, down from $3.1bn at the end of 2018. However, with production and cash flow expected to fall in 2020, cutting debt further could be more difficult.
Investors who own the firm’s bonds — or loans — are starting to price in the risk they won’t get all of their money back. Tullow’s bonds currently trade at 20-30% below their face value. If the firm’s troubles worsen, investors who own these bonds will have first call on the firm’s cash and assets. Shareholders will be at the back of the queue.
What I’d do now
Although I don’t expect Tullow to go bust, I do think shareholders could face another cash call. This could see shareholders face significant dilution and further losses.
In my view, anyone buying Tullow shares today is effectively betting that the price of oil will rise significantly. This would probably bail out the company and provide a much-needed cash boost. However, from what I can see, there’s no good reason for the price of oil to rise much above $60 at the moment.
I see Tullow shares as a high-risk punt that’s best avoided. For exposure to oil, I’d much rather buy shares in the oil majors. BP and Royal Dutch Shell both have diversified operations and much stronger finances than Tullow.
Despite this, the market sell-off has left both of these London oil giants trading on around 10 times forecast earnings, with a dividend yield of around 8%. In my view, this is probably too cheap.
I bought more Shell stock for my portfolio last week. I believe the shares are likely to recover once the coronavirus outbreak moderates. BP and Shell both look like buys to me at current levels.
