Stockwatch: The next oil takeover target

Are the likes of Premier Oil shaping up as a contrarian buy? Experienced investors know the stockmarket is liable to over-punish oil exploration and production stocks during a downturn; the early 1990s recession also showing how they can stay out of favour a long while, as analysts adjust valuations to "bare bones" disregarding exploration prospects.

Yet stocks will eventually recover and takeovers emerge also, as the industry rationalises. Mid-size companies that over-borrowed during the boom years, such as Premier and Tullow presently see their stocks in a self-reinforcing downtrend as debt service costs compound the impact of low oil prices. Care is needed, but both these stocks merit closer attention after big drops, and Premier reports interims this Thursday.

If China is devaluing, it's another game-changer

This is a chief factor among various, whether a deflationary trend is endemic. China's central bank has insisted that three days of devaluing the yuan does not represent a path for the future; indeed some Western economists point out there is little to gain by driving the currency lower amid weak global demand. Yet Paul Krugman argues the opposite, how this is "taking the first bite of the cherry", moreover it begs a question whether the Chinese economy is weaker than a 7-8% growth rate in official statistics.

Over-production of oil by Middle Eastern states amid weak global demand has also conspired to hit prices; and despite US shale producers pulling more than half their rigs oil services firm Baker Hughes Inc has said the overall number of rigs active in the US continues to rise. Such factors combine for a sense the downtrend in oil prices will take time to resolve - some analysts claim, no upturn later in 2016 - although oil markets can always surprise. Stock prices are also likely to recover beforehand anyway, on expectations. Overall, if you are bearish on China then "continue to avoid" for now, however the fuss over China looks curious considering Germany has benefited from an approximate 20% devaluation in the euro versus the US dollar.

Premier has accumulated over £1.5 billion debt, now weighing

Similarly as Tullow, Premier racked up big debts when high oil prices lent optimism, reinforcing the effect of an oil price slump. Thankfully hedging was employed to fix prices for elements of oil production, which the chief executive says makes the debts "manageable at this point in our investment cycle." They have not been enough however to mitigate a profits slump, and it remains to be seen when the hedges expire. Remarkably for a business now capitalised at £550 million, by end-2014 Premier had clocked over £1.5 billion equivalent total debt or £1.3 billion net debt (sterling comparison for context although international oil firms report in US dollars.)

The 2014 results quite obfuscated the interest hit, where the income statement cites "finance costs, other finance expenses and losses" of $196.3 million versus operating profit of $248.1 million, and similarly lumped "finance and other gains" into $58.5 million interest revenue. The only positives are no significant maturities until late 2017, and all borrowings being unsecured.

All this explains the consensus expectation for just £18 million operating profit this year - and the dividend is suspended. It is significantly why Premier shares have fallen from about 330p a year ago to 104p currently, with no floor apparent on the 3-year chart as yet.

Debts relate to a busy investment cycle

The rise in debt relates to an investment programme although the board should have ensured a better margin of safety regarding commodity cycles. The 2014 cash flow statement showed nearly $1.2 billion capital expenditure, up from $878 million in 2013, both amounts modestly above operating cash flow.

A latest investor presentation is well worth reading and cites $2.25 billion capex regarding the North Sea Catcher field, $1.6 billion on Solan and $1.8 billion on the Sea Lion project offshore the Falklands. This investment in the North Sea may be justified by Premier having £3.3 billion of UK tax losses to exploit (significantly the result of an acquisition) although like with many presentations this one doesn't tell you how sensitive the various projects are to oil price changes - i.e. a lot of detail to absorb, which reads like a fine story, but how value-accretive is all this and in what oil price scenarios?

Without such insight, investors tend to withdraw to essentials: Premier's forward price/earnings (PE) looking high and with no guarantee of a prospective yield. Emerging from their closed period surrounding the interims, management could explain net asset values better - especially now the economics of North Sea oil is under question. In fairness, during 2014 they took a $732.3 million impairment charge relating to fields in the UK North Sea, Indonesia, Vietnam and Mauritania, which helps confidence regarding base values. This explains the drop in tangible net asset value per share (see table) however the accounting value bears little relation to intrinsic value of an E&P business. As ever, it's the net present value of what the assets can earn.

Relatively risky geographic profile

This is another aspect to bear in mind: Premier's production profile being 32.5% Vietnam, 27.9% UK, 21.7% Indonesia and 17.9% Pakistan & Mauritania. A south-east Asian bias is intelligent given this is where long-term energy demand is growing strongly, however these countries involve political risks and are exposed to currency issues - a devaluing Chinese yuan and strengthening US dollar - hence Premier shares being affected by sentiment towards emerging markets. The Falklands project has generated doubts this year as a result of lower oil prices, more positively it has also heralded useful exploration progress. Falklands' oil remains controversial, at least for Argentina.

So there are plenty on-going issues for Premier, conspiring to erode the share price - making Premier a potential takeover target for larger oil companies challenged to deliver growth. Reason to pay attention to the underlying progress on Thursday, and thereafter.

For more information see: premier-oil.com.