Edmond Jackson's Stockwatch: Tempted by Tullow?

Is a two-year fall in the share price of high-flying oil explorer Tullow Oil an opportunity or warning sign? FTSE 100-listed Tullow traded over 1,600p in 2012 due to a reputation for astutely "making its own luck" securing international exploration prospects then achieving very good results.

Despite hitting taxation trouble in Uganda hence a dispute with Heritage Oil, this company has enjoyed a leading reputation in the sector - achieving about 1,500% capital growth near its highs, since 1985. But the chart shows a steep and volatile decline from 2013, down 37% in the last 12 months to about 630p currently - prompting some brokers to recommend 'buy', also citing bid prospects. I think this makes Tullow more interesting to follow but all-considered it looks premature to turn greedy for stock.

The situation is a good example how self-reinforcing trends can get established in stocks - up or down - and it's worth bearing in mind, either extreme can persist. Indeed, a dilemma with the most successful firm in any sector is a speculative premium taking hold: for 2010 to 2012 Company REFS shows Tullow's annual average price/earnings (P/E) multiple being at least 80 times and ranging over 160.

Weakening global demand

While the principal measure of value for an explorer is its ability to transform its asset base by growing reserves, if such progress turns volatile then a high P/E makes the stock look especially exposed; and despite Tullow paying out a significant portion of earnings (see table) its yield has never amounted to support. Post 2012 the industry reality of a spate of dry wells prevailed, unwinding this speculative premium. So just because the stock has dropped a long way does not imply a discount to what it is genuinely worth.

This coincides with a second key factor: lower oil prices which signal weakening global demand, especially now China is challenged to manage its 250% debt-to-GDP ratio as industrial production falls to a six-year low. The US dollar has been rising as foreign exchange traders and portfolio investors position themselves for increases in US interest rates (even if only very marginally), and since oil is priced in US dollars this has also crimped demand and created a reversal: this last week Brent crude oil has tested a 12-month low of $95/barrel.

Predicting oil prices is a tricky business

Saudi Arabia is the main "swing producer" but instead of limiting supply it has cut prices to compete with Iran and Iraq for market share. Any cuts among key producers are unlikely to get agreed until late November possibly just ahead of OPEC's meeting on 27 November, which is adding to downward pressure on oil prices currently.

Predicting oil prices is a tricky business, but unless supply is cut soon then the balance of factors weighs negatively. If economic weakness spreads then a serious financial crisis beckons as international debts continue to mount and servicing them gets harder.

The crux would be if central banks' monetary stimulus becomes seen as having failed to restore a proper level of demand in major economies - beyond mainly boosting asset values. Tullow's two-year fall contrasts with the wider stockmarket, but it encapsulates key factors now coming into focus.

Guesswork

Broker share price targets range from 650p to 1,125p, but frankly all these analysts have their fingers in the wind - which changes according to oil prices and exploration results. The aspect of guesswork is shown by this target range being nearer 20,000p, two years ago.

Oil & gas analysts may not appreciate the wider context as they moot takeover prospects: the rationale being, assets and exploration acreage in listed companies now being less risky an investment than doing this from scratch. Furthermore, takeovers help satisfy shareholders in the big predatory oil companies, that a re-rating may still be achieved in more challenging times. Yet for a rival to derive a convincing offer price for Tullow - capitalised near £6 billion before consideration of whatever premium for control - would require taking a view on oil prices, which is especially difficult right now; likewise for Tullow's board to recommend any deal. Success would need a "knock-out" offer I doubt any oil major could justify. So beware this siren call of bid speculation.

The first-half 2014 results showed good underlying progress in production despite a slip in European gas; also developments in Africa proceeding to plan, and some drilling success in Kenya and Norway. The current period, and going into 2015, holds potential for useful news from testing continuing in Kenya and Norway, also Suriname and Gabon.

"High beta" play

The business has net debt of about $2.8 billion (£1.7 billion) and unutilised debt capacity of $2.3 billion. So despite the financial results being down on most key measures, Tullow's progress and prospects justify shareholders continuing to hold - but anyone with a strong weighting in the more dynamic oil & gas explorers/producers is going to need strong nerves for the months ahead. Unlike possibly BP or Shell, Tullow is not going to attract income investors who are likely to ride out volatility; the core of its shareholder base are more likely those higher risk/reward-driven investors now de-risking their portfolios.

So on fundamentals and behavioural finance, with fresh money I would not yet be tempted by Tullow. A shift is underway in general market sentiment, where investors felt positive about the remainder of 2014, but doubts are now increasing. Remember how in August 2011 this stock took a big dive from about 1,300p to near 900p within a few days' trading; it is a classic "high beta" play - i.e. more volatile than the market. The wider economic and political news context is risky and October - historically the hairiest month for markets - has only just begun.

For more information see tullowoil.com.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.